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Friday, September 30, 2011

Plosser Speech

I tend to like Charles Plosser's speeches, and this recent one is no exception. Plosser has an excellent understanding of why central bank commitment to a policy rule is a good thing, and communicates the idea well to a lay audience.

Here is one of the interesting parts:

The ills we currently face are not readily resolved through ever more accommodative monetary policy. If we act as if the Fed has the ability to solve all our economic problems, the credibility of the institution is undermined. The loss of that credibility and confidence could be costly to the economy because it will make it much harder for the Fed to implement effective monetary policy in the future.

We do indeed face ills. A large fraction of the population is significantly worse off than they were in 2007. But there are no monetary policy actions available currently that will make them better off. However, by continuing to engage in unconventional policy actions - QE1, QE2, "forward guidance," and Operation Twist, the Fed is acting as if it knows what it is doing, and can actually reduce unemployment by taking those actions. Further, public statements by some Fed officials, particularly Bernanke, express confidence that these actions actually work. Bernanke, and like-minded people such as Charles Evans, Chicago Fed President, are unfortunately engaged in wishful thinking.

In commenting on his dissent at the August FOMC meeting, Plosser states:

Credibility was also at the center of my opposition to changing the forward policy guidance in August. I was concerned that tying monetary policy to calendar time could be misinterpreted by the public as suggesting that monetary policy is no longer contingent on how the economic outlook evolves. This could also lead to a loss of credibility should economic conditions develop in a way that requires the federal funds rate to be adjusted prior to mid-2013. And in my view, given the outlook, economic conditions will likely warrant that the Fed begin to raise rates before that time.

This is essentially identical to Kocherlakota's justification for his dissent at the same meeting, and it makes sense. While the August FOMC decision may look like it implies more commitment, it actually gives less, as Plosser points out. If inflation happens to be much higher than the Fed forecasts (in fact a serious possibility, given the policy) then there are two possibilities. First, the Fed could choose not to tighten, in which case it loses its credibility for controlling inflation. Second, the Fed could choose to tighten, in which case it violates the promise it made in August. Either way credibility is lost and we are actually worse off than if the FOMC had not made the announcement it did in August.

Finally, Plosser discusses inflation targeting:

An important first step in that direction is for the Federal Reserve to adopt an explicit numerical objective for inflation. The explicit inflation goal would help to anchor inflation expectations, raise policy transparency, and increase the central bank’s accountability for its actions. There is considerable evidence that countries that have adopted such an objective as a cornerstone of their monetary policy decision-making have had more success at achieving price stability without any deterioration in the stability of real activity. In the United States, Congress has given the Fed a mandate to promote the goals of maximum employment, stable prices, and moderate long-term interest rates. Price stability is the most effective way for monetary policy to promote the other two goals. Thus, by helping the Fed achieve and maintain price stability, an explicit inflation objective would help the Fed promote all three of the goals set forth by Congress.

Some people think that the Humphrey Hawkins Act constrains the Fed in such a way that it must speak directly to the second part of the dual mandate, typically in terms of specific goals for the labor market. However, Plosser gives us a way out. Just as many other central banks in the world do, the Fed could announce specific inflation targets (or a price level target, if you like that better). This need not require any authorization from Congress, as the Fed can argue that this actually speaks to the dual mandate. And that is not a lie, as indeed a wide class of economic models tells us just that. In general, the long-run costs of inflation are reflected in real GDP and employment. Further, there are models of short-run nonneutralities of money in which price stability implies that real GDP and employment are maximized. For example, some New Keynesian models work that way.

I'm afraid that just looking at the data does not help us. You need the model. There are a lot of things going on in these periods other than inflation, GDP growth, and employment growth. I certainly cannot infer from observing a period of time with high inflation and high GDP growth and another with low inflation and low GDP growth that inflation is a good thing, can I?

No, of course you can't infer from this that "inflation is a good thing." But don't you find it a bit curious that GDP and employment growth were so much higher during the most inflationary decade of the post-war era than they were during one of the least inflationary decades of this era?

I appreciate your commitment to theory, and no doubt the world is too complex to isolate a few factors in explaining the difference in economic performance over different periods of time. But that said, if someone believes, on the basis of a model or otherwise, that stable prices and low tax rates are among the *most important* economic variables affecting GDP and employment growth, then the 1970's outperformance of the 2000's suggests that these variables may not be as important as one might think.

If Anonymous has the inclination, I'd be interested in an explanation of the 1970's outperformance of the 2000's in terms of Lucas's paper on expectations and the neutrality of money. I love the math, but it's also important to be able to explain things in words.

"But that said, if someone believes, on the basis of a model or otherwise, that stable prices and low tax rates are among the *most important* economic variables affecting GDP and employment growth..."

I am flabbergasted anyone thinks the Fed is doing enough. Really? Inflation is dead, unemployment is at 9 percent, and we are 10-15 percent below GDP growth trend.

A peevish zeal for fighting inflation is a very bad economic policy, as proven by Japan. Real estate and equities markets are down in Japan 75 percent in the last 20 years, and income per capital is falling relative to the USA. Tight money is an abject failure, especially for investors. They have no inflation. And if you judge only by interest rates, they have an "easy" money policy.

In contrast, the Hong Kong Monetary Authority has published studies to the effect that the "revealed preference" of mainland China's central bank is growth before inflation.

Gee, what has happened in Japan and China the last 20 years?

Tight money is a bad economic and foreign policy. If you wish for a less prosperous, declining USA in the future, and a diminishing role on the world stage, then keep braying about inflation. Even when the TIPS market suggests there isn't any.

The Fed could announce it is targeting 7 percent nominal GDP growth, and follow Milton Friedman's advice to Japan, and start printing money. (BTW, John Taylor published a paper in 2006, on his website, absolutely gushing about the positive effects of the QE program then recently undertaken by Japan. In a paper dated Sept. 14. 2006, Taylor writes, "the key to the recovery, in my view, has been the quantitative easing."

Obviously, Friedman said do QE, and Taylor gushed about QE in Japan, So QE worked in Japan as along as it was tried (if you believe Taylor). Bernanke said do QE. So why would not QE work in the USA, if sustained and large enough?

QE even seemed to work here, it just should have been sustained. Things have not been pretty since QE2 ended.

Pray tell, why is QE pronounced a success in Japan by John Taylor, but sure to fail in the USA? So there is nothing we can do? Not cut IOR? Even, though it may sound silly, print money and pass it out through a lottery that has more winners than losers?

For Taylor's paper, see http://www.johnbtaylor.com/ then go to papers from 2006. It is PDF format, so I am unable to pull a cite.

"The Fed could announce it is targeting 7 percent nominal GDP growth, and follow Milton Friedman's advice to Japan, and start printing money."

The Fed can announce whatever it wants. If it can't actually accomplish what it announces, what good is the announcement? "Printing money" would be, I assume, exchanging reserves for some Treasury debt. That will be essentially neutral - no effect on any prices or quantities.

Williamson can speak for himself, but I would imagine he feels Taylor is not a "serious" monetary economist since he assumes nominal frictions rather than derives them from first principles. So Taylor analysis is suspect....

George Gilder is author of the book, "Wealth and Poverty," and for a while a well-recognized right-wing thinker. I am surprised you never heard of him. From Wiki, "His 1981 bestseller Wealth and Poverty advanced a practical and moral case for capitalism during the early months of the Reagan Administration." (Perhaps you are too young for some of this....).

Granted, Gilder was bit of a popular thinker, yet nevertheless had refreshing views on "conservative" economic policy, including the sentiments that emphasis on growth, commercial or economic freedom, innovation was key---and not an unhealthy obsession with inflation or gold.

As to the Phillips Curve, I am agnostic. I am optimistic about the use of sustained QE, in combination with decreased IOR and clear Fed targets for nominal GDP growth. If we get some inflation on the way to robust real growth, that is a price I would pay happily (also useful for sticky wages, and to inflate real estate values, good for banks in that regard. Additionally, small businesses usually can't borrow except against real estate assets. If assets are underwater, you will get little small-business borrowing).

But most of all, starting from the premise that the goal is zero inflation (if you can even measure that) is limiting and self-destructive. The goal of an economy should be growth, prosperity, opportunity, and innovation. Not stable prices (although some stability is necessary).

Add to this that the CPI is thought to over-estimate inflation by perhaps one percent. We may be in deflation now--this confusion about whether prices are fallin or rising underscores just how silly an obsession with low inflation is. Not only is fighting inflation of secondary importance, the very nature of inflation is sketchy.

If you are healthy and buying a house today, you are living in deflation. If you are unhealthy (buying health coverage) and renting, you may be in inflation.

As for Taylor and "serious science," I hope you are speaking in jest. Taylor, though a strict partisan, is a professor at Stanford University, and author of the "Taylor Rule." I hope you have heard of him?

I can only comment that there are times when ideas or causes seem to upend rational thinking. There was a time when the USA poured incredible resources into Vietnam, led by people with very high IQs. With the benefit of hindsight and less emotionalism, we see today that Vietnam was an obvious and colossal error--how could we spend so much to gain so little (and ultimately worse than nothing)?

Today it is taken for granted that inflation is Satan, and even a small amount of it is somehow an ethical, moral and economic failing. Even at huge costs, we must contain inflation.

Really? If we had, say five percent real growth for five years, and four percent inflation, we would all die? We would be de-based? Capital would become scarce? The White House would become a gay brothel?

In some regards, today's obsession with inflation is even less rational than Vietnam. Back then it was thought defeats might be permanent. The Commies would control SE Asia forever, and spread from there across to Indonesia etc.

No one suggests that inflation cannot be tamped down at some point--if we were so lucky as to have five years of robust growth, we could then start tightening the money supply.

"No one suggests that inflation cannot be tamped down at some point--if we were so lucky as to have five years of robust growth, we could then start tightening the money supply."

It's costly to reduce inflation once it gets going, right? What if all your inflation does not produce the robust growth you are expecting. Now everyone is complaining, not only about being unemployed, but about the high inflation rate, just as they were in 1980. Then you have to put them through the wringer again to get the high inflation out of the system. Do you think that will go over well?

"Now everyone is complaining, not only about being unemployed, but about the high inflation rate, just as they were in 1980."

The inflation rate today is in low single digits, and few are complaining about it. Indeed, over the last three years (as measured by the CPI) we are running inflation at about 1 percent. You may wish to consult the TIPS markets for the outlook, which is under 2 percent. The Cleveland Fed is projecting inflation at sub-2 percent. Again, many conservative economists in the past have concluded that the CPI overstates inflation, So we may be close to deflation now.

I lived through the Great Stagflation of the 1970s-80s, and Volcker's subsequent tight money policy. Yes, it was a bad period.

But there is a gulf--a vast gulf--between the 13 to 18 percent inflation rates back then, and the sub-2 percent rates we have and expect now.

It is important for policymakers not to become ossified into certain stances. Fighting inflation is one goal--but there are times when it has to be done, and times when we actually need moderate inflation.

Now is one of those times.

I am amazed you think today's inflation rtes are in any way comparable to the 1980s, and that you seem unaware the TIPS market is telling us inflation is dead for five to 10 years.

Try reading Scott Sumner, at the Money Illusion blog. You seem to be out of touch.

"Now everyone is complaining, not only about being unemployed, but about the high inflation rate, just as they were in 1980."

No, you're not getting it. I'm projecting into the future. I'm saying, suppose your high growth does not materialize, in which case you still have high unemployment, but you also have high inflation. Then what? You just made a bad situation worse. I'm not saying inflation is too high now.

On IS/LM: People working at the frontier of macroeconomics figured this out in the early 1970s, and it took until the late 1970s or early 1980s in some cases for IS/LM to disappear from PhD programs in economics, as we had found superior models. People were clinging to it in undergrad programs, as they couldn't seem to find a way to make what macroeconomists actually do accessible to undergrads. There is no need for that now, fortunately. In early versions of my intermediate macro book, I included a Keynesian chapter which was basically IS/LM and AD/AS worked out in detail. In the last edition, I do a version of Woodford, which I think gets the key Keynesian sticky-price ideas across and is really simple. There are some short cuts you have to take for undergraduates, but there is no particular reason we should teach them IS/LM. Why DeLong loves the thing is beyond me. He's a very weird dude.

I just read the whole Plosser speech and noticed his reference to the terrible "stagflation of the 1970s," a worrisome possibility you mention in your reply to Benjamin. I don't know whether your thinking is informed by the 1970s' bad reputation, but Plosser's thinking certainly seems to be.

Granted, the 1970s was not the prince of decades, but nevertheless the cumulative increase in non-farm payrolls was about 30% at the end of the decade, which looks pretty good compared to the roughly 0% increase over the 2000s. What would monetary policy look like if the dominant disaster image were the 2000s rather than the 1970s?

On a different subject, Sir John Hicks eventually became a critic of J.R. Hicks's IS-LM model.

And, finally, George Gilder was also the author of "Naked Nomads," which argued, with some justification, that unmarried men are the major source of crime and many other social problems.

I wonder if the USA stock and real estate markets are telling us something else--not recession, but neither recovery either. A Japan.

In the USA we are roughly following the Japan approach to a real estate bust-recession, and that is tight money but fiscal deficits.

It didn't work in Japan (for 20 years and counting), and the market is telling us that it will not work here. (In Japan, real estate is off 80 percent in last 20 years and still falling, while equities are down 75 percent). In this regard, I agree with the markets. The stock market did well during our QE efforts.

We have crushed inflation, and it will remain dead, I am sure of that. Derive psychic income from the death of inflation, as you sure are not going to derive any real income from it.

David Glasner thinks you're being inconsistent, but he might be misunderstanding what you actual beliefs about the Fed's capabilities are:http://uneasymoney.com/2011/10/05/the-fed-is-impotent-but-watch-out-for-inflation/

He may be wrongheaded, but he seemed to be making comprehensible criticisms. I can't read your mind, but if someone asked me to pretend to be you and answer him, this is my best guess.1: The Federal Reserve is legally restricted in the actions it can take. None of the available actions can increase inflation. Or decreasing interest on reserves is an unacceptable move.2. Even if we ignored point one, and imagined the Fed really could "print money" and drop it from helicopters to produce inflation, we can't be confident that would reduce unemployment. We could end up with both high unemployement + inflation = stagflation. And then reducing inflation back towards normal would increase unemployment even more?